How to Start a College Funds for Your Baby - SmartAsset

If you have a new baby in your household, you know that the first few months of your baby’s life are chaotic. There are so many decisions to make and life has just gotten more complicated. Many new parents start thinking about their baby’s education in the future and may already have done some planning for a college fund. The average amount of student loan debt for a student graduating in 2021 is $39,351. Compare that to an average student loan debt for 2000 graduates of $17,297. Parents should start planning and saving early.

Be sure to take advantage of the training and insights of an experienced financial advisor as you build a college fund for your child.

There are several investment vehicles you can use to set up a college fund for baby. Here are some you may want to consider.

College 529 Savings Plans

A 529 college savings plan, also known as a qualified tuition plan, is one of the best choices for a college fund for baby. The 529 plan allows you to save money for future education expenses and, as an added benefit, it is tax-advantaged. Even though the federal government does not allow you to deduct the contributions you make to a 529 plan on your federal tax return, those contributions are often deductible on your state tax return. In some cases, a state may offer a tax credit instead. The rules regarding tax-deductibility of contributions are made on a state-by-state basis.

When choosing a College 529 Savings Plan, be sure and choose one that is “flexible.” That means you can move your money between mutual funds within the plan. If you choose a plan that is “fixed” or “life phase,” you won’t be able to stay in control of your money. The amount of your contribution per year is not specified except that the law says you can only contribute up to the expected amount of education expenses. The lifetime limit on contributions to a College 529 Plan is $235,000 to $529,000, depending on the state in which you live. This college fund for baby stays in the name of the parents.

The beauty of the 529 plans, however, is in their tax-deferred growth and tax-free withdrawals. Your investment can grow and appreciate in value and the earnings are tax-deferred. When a distribution is made for qualified education expenses, the distribution, including the earnings, is not subject to federal or state taxes.

If you take a distribution that is not for qualified education expenses, you could be subject to federal tax on that distribution at your ordinary income tax rate plus a 10% penalty. The Secure Act of 2019 relaxed the rules under which you are taxed for a non-qualified distribution. For example, now the beneficiary of a 529 plan can use any leftover money to pay up to $10,000 in student loan debt.

Custodial Accounts

Setting up a college fund for baby through a custodial account is another possibility. A custodial account is any type of account that you open up for another person. They are normally savings accounts or brokerage accounts that an adult opens and maintains for a minor. When the minor comes of age at 18, the account reverts to them. Before setting up a custodial account for educational expenses, you should understand that this type of account will cause any possible financial aid your child could get to take a hit since at 18 years of age the account becomes the property of the child and one of the child’s assets. Usually, about 20% of the amount of the custodial account is counted toward student financial aid and the child loses that amount from any financial aid they might have expected.

There are several types of custodial accounts:

Coverdell Education Savings Plan (ESA) – Families with $110,000 in income for a single individual or $220,000 for a married couple are eligible to establish a Coverdell ESA. Contributions are limited to $2,000 per year, but Coverdell ESA’s can be set up by more than one person. That $2,000 will be magnified if more than one individual contributes to a Coverdell for an individual student. Contributions are not tax-deductible, but distributions from the ESA are tax-free as long as they are used for qualifying educational expenses. Coverdell ESAs can be used for elementary and secondary expenses, along with college and university expenses. All funds must be disbursed before the recipient reaches the age of 30
Uniform Transfer to Minors Act (UTMA) and the Uniform Gifts to Minors Act (UGMA) – The major difference between a UTMA and a UGMA is the type of financial asset with which you can fund them. The UGMA can only be funded with cash, securities, and insurance. The UTMA adds real estate and alternative investments. These accounts are irrevocable trusts. They are the property of the minor children upon deposit and are transferred to them when they become of age. For parents, there may be some tax advantages. Capital gains and dividend income are taxed at the minor child’s tax rate. Since this is usually lower than the parent’s tax rate, this is advantageous. Then, the first $1,100 of unearned income is tax-free. The second $1,100 is taxed at the child’s marginal tax rate. Beyond that, any unearned income is taxed at the estate tax level of 37%. Withdrawals are not taxed since contributions were made with after-tax money. These custodial accounts have often been used to safeguard money so it can be used for educational expenses and not wasted.
Mutual Funds – Mutual funds are not usually the preferred way to set up a college fund for baby. One of the main reasons is that the income generated by mutual funds is taxable. At the end of each year, many mutual funds make capital gains distributions to the investors. In addition, when you cash in the fund to make the money available for educational expenses, the appreciation is taxable income. Capital gains income will show up on the parent’s tax returns. 529 College Plans are a much better vehicle to use to save for your child’s education since they are tax-advantaged. Even the expenses associated with 529 plans are not enough to make mutual fund investment preferable. There are tax-managed mutual funds, but in that case, investments are chosen because of their tax treatment. In 529 plans, investments are chosen based on their merit.
Roth IRAs – Many parents consider using a Roth IRA as a college fund for baby. In most cases, a 529 plan may be a better choice. You can’t make withdrawals from the Roth IRA without a 10% penalty unless you are 59.5. However, if you haven’t had the Roth IRA for at least five years, you will pay the penalty anyway. Even if you can make withdrawals without a penalty, you will be taxed on the earnings from the investments in the IRA. You aren’t taxed on the contributions. If you use a 529 plan, you aren’t taxed on either income or contributions and you can contribute much more than the yearly maximum allowed for the Roth IRA. The distributions from a Roth IRA will affect student financial aid, but the 529 plan distributions will not.
Savings Bonds – Federal savings bonds have been used for decades to fund college educations. The Savings Bond Education Tax Exclusion allows you to avoid taxes on savings bonds if you cash them in during the same year as the educational expenses occur. You must also file a joint tax return if you are married, meet some income requirements, and go to a school that is eligible for federal assistance. As long as you purchase the savings bonds in your name, their impact is minimal on financial aid. Any savings bonds that are purchased for educational expenses should be Series EE or I. Savings bonds can be a good supplemental source of money for college to a 529 plan, for example.

The Bottom Line

It seems clear that the 529 college plans may be the best investment vehicle for a college fund for baby. However, what is actually best may be diversification in your education planning. You can use a 529 plan in combination with perhaps savings bonds or another type of asset to minimize your risk. What’s important is to start saving and investing with future educational expenses in mind.

Tips on Saving for Education

Finding the best way to help fund a child’s education can be difficult, but a financial advisor is often a good tool to help you figure out how to build your portfolio.
Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor, get started now.
Find out whether it would benefit you to refinance your student loans and how much they are costing you with SmartAsset’s student loan calculator.
Calculate the difference between investment options by using the SmartAsset capital gains calculator. It will enable you to see the difference between investing in a tax-advantaged or regular investment.